Join our community of smart investors

Emerging markets and the Trump effect

The rise in value of the US dollar and import tariffs have caused a deterioration in emerging market inflows
December 13, 2018

Recent history tells us that the gradual normalisation of western monetary policy was always going to pose a challenge to emerging markets in attracting foreign investment. However, a deterioration in relations between the US and some developing markets alongside idiosyncratic crises have dampened investor sentiment during 2018, causing a deterioration in local currencies and a sell-off in local debt.

Yet with the appreciation of the US dollar showing no signs of slowing as the year draws to a close, uneven growth among emerging market (EM) economies and the price of Brent crude hovering back around $60 (£46.98) a barrel, could there be worse yet to come for emerging markets in 2019 or have risk premia widened sufficiently to tempt investors back?

This time last year the MSCI Emerging Market index – which captures large and mid-cap stocks in 24 EM countries – had risen to its highest point since 2009, having outperformed the FTSE All-Share over the prior 12 months after fears of a repeat of the 2013 ‘taper tantrum’ proved unfounded. However, during 2018 the former has lost those gains, down 14 per cent on the start of the year, and is trading just below an all-time average of 11 times the next 12 months’ forecast earnings.

The acceleration in the value of the US dollar – buoyed by more hawkish US monetary policy – has a lot to answer for when it comes to the deterioration in EM inflows, with local-currency debt becoming less valuable to foreign investors that calculate their returns in dollars. Meanwhile, the yield on two-year US treasuries has risen to a 10-year high of 2.84 per cent, reducing the attraction of riskier EM debt.

The US Federal Reserve has lifted the Federal funds rate – the cost of borrowing reserves overnight – three times so far this year, with a further 25-basis-point rise on the cards in December. However, there could be some relief in store for EM assets, after Federal Reserve chairman Jerome Powell said US interest rates were “just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth”, in a speech to the Economic Club of New York. 

The comments were interpreted by markets as a sign that the US central bank may slow the pace of rate hikes next year – and by consequence the ascent of the dollar. That contrasted with Mr Powell’s October remarks that rates were a “long way” from neutral levels.  

Jan Dehn, head of research at Ashmore, reckons that given US gross domestic product (GDP) growth – boosted to 4.2 per cent during the second quarter of this year by President Trump’s tax reforms – is expected to slow from next year, the rally in the dollar should subside. The International Monetary Fund has forecast that US real GDP will drop to 2.5 per cent in 2019, from 2.9 per cent this year. Against this backdrop, a more dovish tone from the US central bank is unsurprising, Mr Dehn says. “The Fed should have known that this tax cut was just a sugar high,” he says.  

Based on a comparison of the yield offered by JPMorgan’s EM local currency bond index – which captures 19 local currency bonds – and the 5.25 per cent yield by US treasuries at their 2008 peak, Mr Dehn estimates that EM bonds are currently pricing in a rise in interest rates to 5.2 per cent. “That won’t happen, the Fed will probably stop well before that,” he says.  

Gaurav Saroloya, head of strategy at Oxford Economics, agrees that it is likely that US growth will slow next year. “If the US growth slows in an orderly manner – to around 2 per cent-plus by the end of 2019 – that would put a lid on the extent to which US rates can rise and that will certainly limit the dollar,” Mr Saroloya says. However, a widespread slowdown in economic growth would present the danger of a further flight by investors to the dollar, given its status as a haven asset.  

 

Truly a truce?

Beyond monetary policy, US protectionist trade programmes have riled emerging markets this year. Last summer, President Trump imposed a 25 per cent border tax on around $34bn (£27bn) of Chinese goods imported to the US, including medical devices and aircraft parts. Protectionist measures were stepped up in October – after China responded with its own round of retaliatory tariffs – with a 10 per cent levy slapped on around $200bn of goods, set to rise to 25 per cent. The escalating tit-for-tat has not just stoked concerns around Chinese economic growth in recent months – dampening China’s renminbi in the process – but also other emerging market currencies.

However, emerging market currencies and equities staged a minor rally in December on hopes of a reprieve in a spiralling trade war. The US agreed to a 90-day delay on raising the second, more far-reaching set of tariffs at this year’s G20 summit in Argentina. China, meanwhile, will purchase a “very substantial” – although unspecified – amount of farm, energy and industrial goods to reduce the trade gap with the US. The news caused the onshore Chinese Renminbi to rise 1.8 per cent during the two days immediately following the temporary truce – the biggest gain in the currency since July 2005. Meanwhile, the Mexican Peso, Brazilian real and South African also regained some ground.

However, markets may have been too quick to display their relief. “It feels like a fragile truce because the underlying fundamental differences between the China and the US sides are so profound and deeply entrenched,” says Mr Saroloya. The temporary agreement may have bought some time for negotiators to establish better relations between the two nations, but thorny issues such as China’s alleged intellectual property theft and forced transfer of technology remain to be tackled.

Meanwhile, differing interpretations of the outcome of Mr Trump’s meeting with Chinese premier Xi Jinping emerged. US and Asian stocks gave up previous gains after a series of characteristic tweets from Mr Trump in which he stated he was a “tariff man”, adding: “We are either going to have a REAL DEAL with China, or no deal at all – at which point we will be charging major Tariffs against Chinese product being shipped into the United States”. However, a day later in a statement made by an unidentified person, the Chinese commerce ministry said it was “confident” a trade agreement could be reached with the US within 90 days.

However, there are more entrenched factors that could stymie Chinese economic – and by extension emerging market – growth. “Our view has been that it’s not just a trade tariffs and high US yield story,” says Mr Saroloya. “It’s much more of a reflection of a slowdown in emerging markets themselves.”

Emerging market sentiment remained positive throughout 2016 and 2017, despite the Fed beginning to increase interest rates. “The main reason for that was that EM growth was doing quite well at the time,” he adds.

The Chinese government’s crackdown on the country’s shadow banking industry – where off-balance-sheet funds are lent at higher rates, typically to companies without access to traditional banking loans – may have been a prudent measure to limit the risk of potentially toxic loans infecting the wider economy, but it has also restricted the availability of credit.

That has exacerbated the impact of the government’s shift away from a credit-fuelled growth model, based on heavy manufacturing and infrastructure investment, to one based on domestic demand and services. China’s GDP dipped to 6.5 per cent during the third quarter, its lowest quarterly growth figure since the financial crisis. Given China is the largest global consumer economy, that does not bode well for the health of the wider EM sphere.

Emerging markets seem likely to suffer further volatility as the US-Sino trade dispute is hashed out and investors await to see whether Chinese fiscal stimulus measures boost the country’s economic growth. EM assets should only make up a small portion of a retail investor’s portfolio and are best accessed via actively managed funds. Our most recent buy tip was JPM Global Emerging Markets Income Trust (JEMI), which made a 71 per cent return net asset value return between its launch in 2013 and October this year, against a 45 per cent return for the MSCI EM index, according to Winterflood Securities. The trust traded at a 7 per cent discount to NAV at 5 December, according to Winterflood, and offers an attractive yield of 4.29 per cent. Its managers aim to build a more defensive and conservative exposure to emerging markets, seeking companies that can provide sustainable growth and income for many years.

UK equities: relative values, external levers

Aim-ing for growth in 2019

The UK economy - Trouble ahead

Must politics always weigh on European stocks? 

Japan: Abe's arrows still on target

US equities: losing their bite

Emerging markets and the Trump effect

2018: The year in charts

FX: Too early to call the top of the dollar rally?

Brexit: Businesses scramble to adapt

Where are next year's IPOs?

Asset Allocation: Favouring durability and defensiveness

What fund managers expect in 2019

Resources: Calling time on fossil fuels?

Housebuilders set for a squeeze

Alternative routes to profit

Enter our Quiz of the Year for the chance to win a case of champagne